Fed’s Stein says liquidity regulation has key role for stability

Fed is enacting new powers setting standards

Federal Reserve Governor Jeremy Stein said liquidity regulation is essential to financial stability, while noting a need for a more moderate approach to such oversight compared with supervision of capital.

“Liquidity regulation involves more uncertainty about costs than capital regulation,” Stein said in remarks prepared for a speech today in Charlotte, North Carolina. “Even a policy maker with a very strict attitude toward capital might find it sensible to be somewhat more moderate and flexible with respect to liquidity.”

The Fed is enacting new powers setting capital, liquidity and risk management standards under the 2010 Dodd-Frank Act overhaulingfinancial regulation. Central bank officials aim to prevent a repeat of the financial crisis in which liquidity vanished for many firms, contributing to the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc.

Too much demand for liquidity, particularly during a financial crisis, could lead to a shortage of liquid assets, Stein said. Though the Fed can act as a lender of last resort, this may induce financial institutions to be less prudent.

Regulators should aim to “strike a balance” between reducing reliance on the Fed as a lender and “moderating the costs created by liquidity shortages on the other hand -- especially those shortages that crop up in times of severe market strain,” Stein said at the 2013 Credit Markets Symposium, sponsored by the Richmond Fed.

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Stein’s speech provided an overview of the rationale and challenges behind the Fed’s liquidity regulation. He did not comment on the economy or the outlook for monetary policy in his prepared remarks.

In an April 17 speech in Washington, Stein highlighted liquidity regulation, along with more robust capital requirements and stress-testing as key to the Fed’s efforts to prevent a systemically important institution from “finding itself at the point of failure.”

Rather than opting for caps on the size of banks or a forced separation of banking from investment banking and trading, Stein said regulators should stick to their policy of capital surcharges for size and complexity and watch how this mechanism changes banks over time. If those surcharges aren’t high enough, regulators could change them, he said.

Chairman Ben S. Bernanke after the financial crisis raised analysis of financial stability to an equal footing with monetary policy, creating the Office of Financial Stability Policy and Research to monitor markets and financial institutions for risk.

Bernanke has worked with Daniel Tarullo, President Barack Obama’s first appointee to the Federal Reserve Board, to overhaul supervision and regulation. He has also mobilized economists, lawyers, and payment systems experts to oversee the biggest financialinstitutions in a group called the Large Institution Supervision Coordinating Committee.

Before joining the Fed in May, Stein, 52, was an economics professor at Harvard University in Cambridge, Massachusetts.